Abstract
A typical household has a home mortgage as its most significant financial contract. The form of this contract is correspondingly important. This paper studies the choice between a fixed-rate (FRM) and an adjustable-rate (ARM) mortgage. In an environment with uncertain inflation, a nominal FRM has risky real capital value whereas an ARM has a stable real capital value. However an ARM can increase the short-term variability of required real interest payments. This is a disadvantage of the ARM for a household that faces borrowing constraints and has only a small buffer stock of financial assets. The paper uses numerical methods to solve a life-cycle model with risky labor income and borrowing constraints, under alternative assumptions about available mortgage contracts. While an ARM is generally an attractive form of mortgage, a household with a large mortgage, risky labor income, high risk aversion, a high cost of default, and a low probability of moving is less likely to prefer an ARM. The paper also considers an inflation-indexed FRM, which removes the wealth risk of the nominal FRM without incurring the income risk of the ARM, and is therefore a superior vehicle for household risk management. The welfare gain from mortgage indexation can be very large.
Highlights
The portfolio of the typical American household is quite unlike the diversi ed portfolio of liquid assets discussed in nance textbooks
The monthly interest rate survey of the Federal Housing Finance Board shows that long-term nominal FRMs accounted for 70 percent of newly issued mortgages on average during the period 1985–2001, while ARMs accounted for 30 percent
We study the optimal consumption and mortgage choices of investors who buy a house early in life
Summary
The portfolio of the typical American household is quite unlike the diversi ed portfolio of liquid assets discussed in nance textbooks. Caplin, Freeman, and Tracy [1997] and Chan [2001] emphasize that re nancing can become impossible if house prices fall below mortgage balances so that homeowners have negative home equity Their income, volatile labor income, or high risk aversion are adversely affected by the income risk of an ARM. The monthly interest rate survey of the Federal Housing Finance Board shows that long-term nominal FRMs accounted for 70 percent of newly issued mortgages on average during the period 1985–2001, while ARMs accounted for 30 percent. Some personal nance authors clearly think that income risk and real interest rate risk are important for homeowners, because they describe ARMs as risky assets and FRMs as safe: “An ARM can pay off, but it’s a gamble.
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